Depreciation

In continuation from the topics of yesterday, we gather that one of the most important limitation of the accounting system is it is just a very rough estimation, whereby its output is as good as the inputs which in turn is dependent on how aggressive or conservative the person estimating the accounts is.

One of the subset of accounting that is very important to determining the outcome of the Income Statement is Depreciation. Depreciation is a very straight-forward component of the accounting system where it shows how clear-cut that accounting is in fact just a system of estimation, and not a precise system.

For any new car owner, they will know that once the new car is driven off the dealer's lot, the car will lose a value of anything between 10% to 30% of its original cost, in generally accepted accounting principles (GAAP), it is called depreciation. Well, in some cases, they're not actually totally in the nature of depreciation, it lies more towards the nature of devaluation. Like in this example, the very next day even if you do not drive the new car for a single mile and you want to sell it, straight away you lose a certain percentage, is that a depreciation or devaluation? So what is the difference? Depreciation is associated with wear and tear. So for a car that is as good as new which is not driven, how can it be classified as depreciation for the value that is lost? That is devaluation, a loss of value due to its relative attractiveness.

To continue on the car example, suppose you own a taxi company that consist only one taxi. Your biggest expense would be purchasing that taxi, so what is the best way to account for this expense? You could simply expense it all in a single year which will cause some very absurb scenario. For example, in the first year, if the taxi cost $30K with a scrap value of $5K at the end of the useful period, and you account all the depreciation in the first year, and also on average you can earn about 20% yearly on what you spend on the taxi, you will see a very absurb loss of $19K. And in the subsequent year, you will see a profit of about $6K till the taxi is scrapped. This manner of expensing the cost will cause wild fluctuation which distorts the actual picture from the start to the end.

What GAAP tries to do is match sales and expenses in the same time period. It does this by requiring all companies to make a few estimates on capital assets: the useful life of the asset, the salvage rate, and the depreciation rate. This way, an estimated expense can be matched with the sales the asset generates.

There are many different types of depreciation. The vast majority of companies use the straight-line depreciation method. This method, for example in the taxi company, the taxi costs $30K, it is estimated to be able to last for 10 years with a scrap or salvage value of $5K at the end of the 10 years. If we take the difference between the taxi's cost and the salvage cost, we get a total depreciation cost of $25K. Because it is estimated to last for 10 years, the annual depreciation cost is $2.5K.

So if we use the straight-line depreciation method to account for the taxi company income, it will show a better reflection of the profit that is made from year to year. In the first year to the last year assuming the return is 20% of the taxi cost, it will make a profit of $3.5K yearly for the 10 years.

And now if you compare the two methods of depreciation, clearly, you can see that the first method is a very bad reflection of any of the given year profitability although both method will give a total profit of $19K for the 10 year period of the taxi operating life span.

Also, depreciation is a tool that can be exploited. In a hypothetical example, in the low-cost airline industry, Aircock, expensive planes will make up the bulk of the company's asset, so the depreciation expense is critical to the income statement. If we go into the company financials and look under "accounting for long-lived assets," we can gather that Aircock thinks its aircraft and engines will last for between 18 to 20 years with a residue value of 15%.

Frankly, other that being a normal traveller, I'm no expert in aviation, so I can't gather much from only one airline. So in another low-cost airline, Tiga Air, in one of the footnotes stated under its "summary of significant accounting policies," it says that its aircraft will last between 20 to 22 years with a residue value of 20%.

Between the two above airlines, Tiga Air, has a slightly more aggressive accounting system, but not too much that causes a concern.

So here is another airline, Jet Black, it states its aircraft will last for between 27 to 30 years with a residue value of 25%.

So what now if you compare Jet Black with Tiga Air or Aircock? Any normal investor will probably not get into such details usually, but they would be lucky if some very cautious investor will raise the red flag. The accounting practice is much too aggressive compared to Tiga and Aircock. Although for the residue value of Jet Black of 25% seems only 5% more than Tiga Air, that is only on the surface because how could it be the residue value of a 27 to 30 year old plane be more than the residue value of planes which are 20 to 22 years ones (Tiga Air planes) or 18 to 20 years ones (Aircock).

In conclusion, depreciation expenses are meant to estimate how much "wear and tear" expense should be matched against yearly sales based on how much was paid on the asset, how much the company thinks the asset might sell for when they scrap it, and how long the company thinks the asset will last. Ultimately, you should take a look at what assumptions a company is making, go to the footnotes. That's where the story is told. If you see things that you cannot understand or are made to look complicated, it is most likely that the person telling the story does not want you to understand. So why does someone not want you to understand? It could be more than meets the eye.

Deferred tax liabilities

As noted earlier, deferred taxes exist because of the difference in accounting methods for shareholder income (what the company tells the shareholder) and taxable income (what the company tells the taxman).

In deferred tax liabilities, let's use an example here. If Popeye was always asking for his spinach today in exchange for payment the next week, he is actually getting the benefit upfront while delaying his payment for as long as he can. Like Popeye, businesses want to do the same thing with their taxes. The longer they can defer taxes, the longer they have use of that cash, which means they can use it to make more money - free money without incurring interest.

When companies delay their tax payments, they create deferred tax liabilities accounts (DTL) to reflect future tax obligations. The most common reason for DTL is depreciation. When a business buys property, plant and equipment (PPE), it makes assumptions or estimations that either depreciate this PPE slowly or quickly. To the shareholders, the business will want to impress them with higher income and thus, depreciate it slowly. For the taxman, the company accelerates depreciation which lowers income and tax payments.

In theory, the amount of DTL will reverse over time when the company will eventually have to pay up. As a result of all these, the company books DTL to reflect future tax obligations.

To throw a little confusion into the mix to challenge what is theoretically taught, DTL can be permanent where the situation will not reverse. For example, many companies are growing and continually adding PPE, and the depreciation method remaining the same.

Fairly asset-intensive companies like Kroger, Wal-Mart generally have to build more stores in order to increase revenues. Thus, PPEs of retailers like these increase over time, and the difference in speed between shareholder and taxable depreciation methods tends not to reverse.

In some cases of DTLs, not only does it tends not to reverse but it will never reverse. For example, at Berkshire Hathaway, they are sitting on some very pretty, fat and hefty future capital gain taxes, all thanks to their astute investment selection. Of these astute investments, one of it is Coca Cola which cost them $1.3 billion. Today, it is worth $9.6 billion. The capital gain of $8.3 billion is taxable at 35% if they were to sell today. And if we assume that they would and upon the sale, they would have to set up a deferred tax liability to reflect Berkshire's potential future tax liability. They will have to set aside $2.9 billion. However, because Berkshire may never sell (as you know, their favourite holding period is forever), the DTL on these long-term holdings occupy some sort of netherworld between the nature of an equity (what Berkshire owns) and the nature of a liability (what Berkshire owes).

So, when figuring out DTL, try to understand the source of the difference in shareholder and taxable income, and if the difference is valid. In BH case, obviously, DTL related to permanent equity holdings are unlikely to reverse, so investors can take comfort knowing that they won't get stuck with a huge tax bill anytime as long as the right man is in charge there.

Deferred Tax Assets

Accounting is one of the most amazing, interesting and ungodly smartest invention of the modern world especially towards the contribution of how it advanced capitalism. Having said that, it is also extremely important to know its limitations, particularly on how things are accounted for. As you may be aware, accounting is just an estimated, not a precise system. For example, the most basic difference is in depreciation, SIA may have a 10 years depreciation policy while Qantas may have a 15 years policy, the way this difference will work out will be all-important to the bottomline with all other things being equal. Thus, there are some areas in the financial statements an investor should train himself or herself to look out for, which will ultimately reduce many unhappy incidents (and of course increases your chances of getting the right pick) which he or she would have otherwise encountered if they had not taken note of.

One area of the balance sheet which can be both frustrating and obscure is known as the deferred tax items. Everyone would have an idea what role "accounts receivable" and "property plant and equipment" play in the balance sheet. But Deferred Tax items? As the name suggests, it is some sort of an asset which a business will receive in the future. But what role does it plays? Let's take a closer look.

Deferred taxes exist because the accounting for the shareholder's income (what the company tells you) and taxable income (what the company tells the tax man) are different. You may ask why. Let's say you're on a date with an attractive person of the opposite sex, and this person politely asks you your disposable income. You employ a brilliant accountant who was able to make your income look like it was $0, thus exempting you from paying any taxes. Would you thus triumphantly declare to your date that you made all of zero dollars in taxable income last year? So, if you put that picture on to the business world, it is similar. Companies paint as dreary a picture as they can to the tax man in order to reduce or tax payments, but to someone they're trying to impress (shareholders), they'll probably show a rosier picture. Here, the large part has nothing much to do with how good you are towards understanding finance, it is more on how you understand human behaviour - of which Charlie Munger advocates as all-important if you want to succeed in anything.

In deferred taxes, there're two parts - Deferred tax assets and Deferred tax liabilities. We shall start with the fairly easier to understand part: Deferred Tax Assets. Think of deferred as delayed, or somewhat in the future. We know what taxes are, and we know that assets are a positive thing. In other words, deferred tax asset (DTA) is a future tax benefit. A DTA is created when shareholder income (what the company tells you) falls short of the taxable income (what IRAS sees). A DTA is somewhat the same as a Prepayment or prepaid tax.

Deferred tax assets can result from Warranties, restructuring charges, net operating losses, and unrealized security losses. For example in Restructuring charges, USG is a prime recent example, they're poised to receive a tax credit of USD1.8 billion some time this year due to their emergence and settlement from Chapter 11. Another example will be in Warrenties, Courts and Best Connection sell ton of electronics that come with multi-year in-house warranties. Every year, these companies have to estimate on their future warranty expenses based on how many returns they think they'll get. The company tells you - the shareholder - these estimates, and expenses them on that year financial statements, thus decreasing shareholder income which in turn decreases shareholder taxes. However, IRAS says that warranty expenses cannot be recognized until the actual event takes place, and as a result, shareholder income is lower than taxable income. Thus, until such warranty expenses take place when the item is return, would Courts or Best has to report higher income (and thus pay higher taxes) to IRAS. This results in a deferred tax asset account simply because Courts or Best has prepaid these warranty taxes and will receive a future benefit (lower taxes) when the warranty event actually occurs.

As highlighted at the outset, accounting is just an estimate and many times, A does not equals to B and thus you need to insert C into the formula to make it A+C = B. Here B is to be Deferred Tax Asset intially estimated or expected. A is the actual Deferred Tax asset that will be received and if A falls short of B, how do you account for that? You need to create an account called "Allowance" which in this case is C. So A+C = B.

In other words, if a company does not think it will receive the full benefit of a DTA (B), it can offset this with a valuation allowance in order to be more conservative. For example, a company losing tons of money will have lots of NOLs (net operating losses) in the form of DTAs. These NOLs can be used to offset future income, which lowers taxes. But, if a company can't reasonably expect to make a future profit, then it'll never reap the benefit of those NOLs, and a valuation allowance must be set up to reflect this.

Here, a word of caution, in today world of creative accounting, you should keep a watchful eye on valuation allowance. The fact is since Valuation Allowance is an estimation by the management standard where they can be either conservation (reserve too much) or aggressive (reserve too litttle), this is a very subjective matter that can lead to manipulation of the company's earnings. For example, if a company has a $100 million valuation allowance to offset $100 million in DTAs, and in a particular year, the management realizes that they're going to miss earnings by $10 million, it can make a slightly more aggressive assumptions to release $10 million in its valuation allowance to make up for the expected shortfall, this release from Valuation allowance will flow to net income and thus, allows the company to meet earnings forecast by whoever.

Calculating intrinsic value for business with earnings partly reinvested and partly redistributed as dividend

This is in response to a fellow value investor, Jojo, who asked if it is better to take into consideration of dividend payout in calculating the intrinsic value. Again, I agree with her view if the business you are evaluating does have a dividend policy. I mean whether you calculate your intrinsic value by either way - that is 1) the company does not give out dividend and reinvest every penny or 2) the company gives out part dividend and reinvest the rest - the basics in calculating the intrinsic value are the same. The difference is you get a more accurate outcome if you can manage to make an intelligent guess that will be close to what will happen in the future.

Before going further, what I did before was just a very very rough estimation, just a general guideline. And I am glad you pointed out about how dividend can affect the outcome of the intrinsic value which I totally agree. I gave it some thoughts earlier but did not go further than having the thoughts. Now that you pointed out, here is what I did and the outcome is like what you say, it is definitely very different if all earnings are reinvested.

If we put the exact same principle of intrinsic value - which states that intrinsic value is a value which is all the cash and earnings, irregardless of it given out as dividend or retain in the business, that an investor will receive in the future, discounted at an appropriate interest rate back to today - to use, the basic notion is still the same.

In the same example as given earlier in Walgreen, there will be two parts to the intrinsic value if I calculate the intrinsic value based on the business having a dividend policy.

The first part is the intrinsic value of the capital gain for the timeframe that an investor has, for my case, it is 20 years. This capital gain has accounted for all distribution of dividend that are paid out, that means calculation here is based on earnings that are reinvested.

The second part is the intrinsic value of all the dividend that an investor would receive, discounted back to today.

Here is how it is calculated. The variables needed are: 1) 2006 book value is $9.92, 2) ROE is 19% and 3) dividend policy is estimated at 15% payout of earnings.

In 2007, the business will earn $1.88 ($9.92 x 19%) per share. Out of this $1.88, the dividend given out will be $0.28 per share. Therefore, at fiscal ended 2007, the book value will result as $11.52 ($9.92+$1.18-$0.28) per share. So to estimate the intrinsic value for 20 years, all you need to do is the repeat the process for another 19 times.

After you have repeated that process up to the 20th year, you will get a book value of about $198.11. The intrinsic value for this gain in book value between this 20 year investment timeframe will have to be deducted with the earnings you would otherwise have earned in an alternative risk-free investment like bonds. So the earnings from the reinvested capital which results in the growth of the book value from $9.92 to $198.11 is $188.19. Then you have to deduct this earnings from reinvested capital from the earnings from bonds of $74.42. This results in an intrinsic value of a future amount of $113.77. And then you have to discount it at an appropriate interest rate (5.25%) back to today value, which results in an intrinsic value of $40.88 at today value for the gain in reinvested capital.

And also, you will have a list of all the yearly dividend that are given out yearly - $0.28 in 2007, $0.33 in 2008....$0.94 in 2015...and $4.86 in 2026. Remember all these future dividend cash outflow to an investor is at a future value. Again you must discount it back at 5.25%. The dividend received in fiscal ended 2007 of $0.28 is worth about $0.27 today. The dividend received ended in 2008 of $0.33 is worth about $0.30 today. In 2015, the dividend of $0.94 is worth $0.59 today. In 2026, the dividend of $4.86 is worth $1.75 today. So now you have to add up all these future cash dividend flow for all the 20 year you would expect to receive, it results in a total intrinsic value of $16.02 for all these 20 years of dividend cash flow.

So what is the intrinsic value of the business? You have to add both the intrinsic value of the reinvested capital of $40.88 and the intrinsic value of all the dividend cash flow of $16.02. It gives you a total of $56.91.

So at the price I bought which is $41, that equates to paying 72% of all the future 20 years of cash flows. In other words for every present value of dollar for the next 20 years of cash flow, I am getting a 28% discount for each dollar at today value for the future.

Why is a dollar worth of A is different from a dollar worth of B?

Is a dollar of asset worth in A the same as a dollar of asset worth in B? In all businesses, asset classes and investment types, the ability for each of the different asset of generating future value worth of earnings varies, even though on paper both are carried at equivalent worth.

In traditional Benjamin Graham's method, one of the principles is to buy a business at less than a dollar worth which is carried on paper. That is, for every dollar worth of asset, you must not pay more than a dollar in order to have a margin of safety. However, many times, this principle can be very misleading in the sense that many such deals could be a "cigarette-butt" kind of business. Imagine if you pick up a cigarette smoked almost to the tilt by the sidewalk, you can perhaps take a last puff out of it and nothing more. It may appears cheap but it will not last. And that's pretty much it.

Let's assume A to be government bond and B to be a stock equity or a private business available for sale. In a government bond, if you invest a dollar, it is represented on paper as a dollar. In other words, the price-to-book ratio in bonds is 1.

Whereas in stock equity or a private business, it is not neccessarily so. Sometimes, the stock price is worth less than what is carried on paper, sometimes, it is more, and some other times, it is equal.

From the above, we can deduce that a dollar carried on paper is just an arbitrary figure and gives no meaningful deduction as to what the dollar can generate in terms of output in the future.

The next question to ask is what is the actual value of a dollar worth in each different asset class that you should pay for. In other words, what ratio an investor should pay in relation to what a dollar of asset is carried on paper.

For example, if you have a dollar to invest in either bond or a business, which will be the better option? To determine the better option, another fact is a dollar invested in bond is carried on paper as a dollar. While a dollar invested in the business is carried on paper as 25 cents.

In this example, if you follow strictly on Graham's theory, you'll never pay each dollar for every 25cents worth of assets. But here, Graham missed an extremely vital point in which every asset is very different in nature. For example, a residential or commercial property asset that is worth $1M is very different from a million worth of Coca Cola's plant and equipment. A more clearcut example is if you buy a dollar worth of Louis Vuitton handbag, immediately, even if you do not use it and want to resell on the market, it'll be worth at $0.70.

Thus, for a pure Grahamite, between investing in bond or in the business, the obvious choice is to go into bonds. So let's fast forward to 20 years later to see the result between these two asset classes.

In bonds, for every dollar invested will be worth $2.78 at the end of a 20-year period at an interest rate of 5.25%. On the other hand, in the business, a dollar paid for every 25cents worth of the business asset will grow to be worth $8.11 worth of assets at the end of the 20 years, assuming the return on equity of the business is 19%.

Hence, what is clear here is the 25cents worth of asset today is worth far more than the dollar worth in bond. So paying a dollar for every 25cents in the business is a far superior investment than to pay a dollar for every dollar of bond.

And if we discount both values of the business and the bond at the end of the 20 year back to the present value of today at an inflation rate of 2.2%, the present value of the business is worth $5.13 and the bond is worth $1.76, respectively.

Riches and Price versus Wealth and Value

Like Warren, most of us will find the best way to own a business is owning parts of it through the stock market. Over time, if you end up being smart at the investment game, you can use the earnings of your business to acquire more ownership in the same business or in other business, and eventually, the whole business. Actually, investing in a business to build wealth may be easier than starting and managing your own business. That’s been the Warren Buffett strategy.

With the approaching Chinese New Year, maybe it is a good time to think deeply about the difference between being rich and being wealthy, and price and value. Being rich is having money, which can be temporary in nature and is often brief. Riches are about excess and indulgence. Ask yourself how long you would be able to feel the happiness and desire after you bought a piece of dress, pants, shoes, watch or even a luxurious car which you have been eyeing for some time. Whereas being wealthy is having knowledge, doing what you enjoy, learning about things you like, expanding your knowledge and horizon of views on life, personal relationship success, a sense of humor, and a basic foundation of principles. Price is what you pay and whereas value is what you get. For example, you may pay a high price for something whereby you cannot extract any value more than the price out of it.

So the focus to life success should be on the principles of becoming wealthy: firstly, to acquire knowledge, to have a desire to keep learning so that your interest can be sustained because if you stop learning, naturally interest will deteriorates too. Then with knowledge, you are in fact accumulating wealth over time and with the right principles, you can pass it on to the future generation like what Warren, Bill, Andrew, Benjamin Graham and many others did, for the good of society. It does not matter if you adopt some or all of these wealth principles, most importantly, one must be able to make sense out of it. Warren said it best, “Money will not change how healthy you are or how many people you love.” Money may decide who gets what opportunity but over time, you measure success by knowing who loves you and what makes them love you, and the process of getting there rather than the proceeds.

He still lives in the same house since 1958, still eat the same food and have the same drink he had all along. According to him, a man is rich to what he has, and a man is wealthy according to who he is. So true wealth is not in how much he’s worth but rather his character and values on how he sees the world. There’s no quick get-rich scheme or sure-to-get-rich scheme in this world. Instead, a better approach is a get-rich-slow program which has been tried and tested with the wealthy principles as earlier pointed out. And this involves patience, focus, lots of hard work, an unyielding endurance, and application of these principles, and all this are controllable by a person. A lady once asked at Berkshire annual meeting: “Mr. Buffett, I only have one B share,” And he interrupted and said, “That’s ok, lady. Between you and me we own half the company. What’s your question?”

So from this, it kind of gives an insight into how he views things. With the extraordinary wealth and timeless principles, Warren has a platform and the opportunity to teach and advance investment and life education. He takes you from outside of riches and price to the inside of wealth and value. If one can distinguish the meaning behind the difference of "Riches and Wealth", and "Price and Value." It is one of the highway to a better quality of life.

How would you design the world?

One of the many benefits of the internet is the ability to view the speeches and gleaning the thoughts of some of the world’s greatest thinkers in history. Some of the best are people like Warren Buffett, Bill Gates, Charlie Munger, Charles Darwin, Andrew Carnegie, and so on. I consider Warren Buffett as the most rounded thinker of all time for the reason of how he view wealth, how the world is constructed, how human reacts which enables him to understand almost fully how the world works which in turn brings him to where he is. Besides having a certain intelligence, he is able to grasp the psychological side of the world in such a way that when combine with the conventional method of success or wealth building, the mixture compounds the success of what he set out to do. He is one person who mix investing lessons with life lessons and the following are what I stumbled upon all the while from him.

Let’s just assume it was 24 hours before you were born, and a genie came to you, and he said, “Warren, you look very promising, and I have a big problem. I’ve got to design the world in which you are going to live in. I have decided it is too tough and I shall allow you to design it. So now you have 24 hours to think of how to design. You figure out what the social rules should be, the economic rules and the government rules, and you and your kids and their kinds will all live under those rules.

Oh now, you’d be thinking, “Oh man, I can design anything? There must be a catch.” The genie says, “Yes, there’s a catch. You don’t know if you are going to be born black or white or yellow, rich or poor, male or female, able-bodied or disabled, bright or retarded, born in a first or third-world nation. All you know is you are going to take one ball out of a gigantic barrel consisting of 5.8 billion balls. You’re going to participate in the ovarian lottery draw which will decide where you’ll be born, black or white, rich or poor, smart or retarded. And that is going to be the most important thing in your life, because that is going to control whether you are born here (in a first-world nation) or in Afghanistan or whether you are born with an IQ of 130 or an IQ of 70. It is going to determine a whole lot. So what type of world are you going to design before you draw your ball among the lot?

So before you draw the lot, it is good to look at the social questions, because not knowing which ball you are going to get, you are going to want to design a system that is going to provide lots of goods and services, because you want people, on balance and on the whole, to live well. So now what kind of world would you design besides the obvious things like everyone gets an afternoon nap and coke for free? It is better to design a world where everyone has a fair shake at success. You may not require that everyone has the exact same skills, but an ideal world would have everyone starting off on a level playing field. For example, you’d perhaps create a world where every child has a home and a caring adult or two who will watch over the child and let him or her know that someone cares, or a world where they is an equal chance for a basic education.

Unfortunately, the world we live in is not ideal. There are children throughout the world – in the thousands – who don’t have a home, who don't have an adult looking out for them, who don't get a sniff at an education. They may be in an institution where they have enough to eat and a bed in which to sleep for those so-called luckier ones among this unlucky lot, but that’s pretty much it.

Fortunately, however, there are people like Warren Buffett, Bill Gates and in the past, Andrew Carnegie who truly see through the meaning of wealth by distributing most of what they have back to society. In Andrew words, “Huge fortune that flows in large part from society shall in large part be returned to society.” In Warren words, “I want to give my kids enough so that they could feel that they could do anything, but not so much that they could do nothing.” “it makes sense for high compounder to take care philanthropy needs.” Then if you look at those many others who passed down their fortunes generation after generation, the money withheld does not help either the family themselves or the world at large. Many families are torn apart or many individual got slackened to the point of being a slouch, having no objective in life because they do not value the meaning of achieving and contributing.

The following two quotations from 1995 and 1988, respectively, highlight Warren Buffett's thoughts on his wealth and why he long planned to reallocate it:

"I personally think that society is responsible for a very significant percentage of what I've earned. If you stick me down in the middle of Bangladesh or Peru or someplace, you find out how much this talent (his investment skill) is going to produce in the wrong kind of soil... I work in a market system that happens to reward what I do very well - disproportionately well. Mike Tyson, too. If you can knock a guy out in 10 seconds and earn $10 million for it, this world will pay a lot for that. If you can bat .360, this world will pay a lot for that. If you're a marvelous teacher, this world won't pay a lot for it. If you are a terrific nurse, this world will not pay a lot for it. Now, am I going to try to come up with some comparable worth system that somehow (re)distributes that? No, I don't think you can do that. But I do think that when you're treated enormously well by this market system, where in effect the market system showers the ability to buy goods and services on you because of some peculiar talent - maybe your adenoids are a certain way, so you can sing and everybody will pay you enormous sums to be on television or whatever -I think society has a big claim on that."

"I don't have a problem with guilt about money. The way I see it is that my money represents an enormous number of claim checks on society. It's like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing. I don't do that though. I don't use very many of those claim checks. There's nothing material I want very much. And I'm going to give virtually all of those claim checks to charity when my wife and I die."

The idea of people like Warren is to leave the world a better place when they are gone, by living below their means and giving back their money to society.

Warren Buffett exact words on Intrinsic Value

This is Warren Buffett answer to a question posed on what is intrinsic value is about.

He remarked, "Intrinsic Value is the figure you would come up with if you knew what all the earnings from a business would be between now and what would eventually be disappeared - I mean between now and judgement day. And it's a measure of the cash a business would be able to distribute, whether one year from now or 10 years from now or 50 years from now, discounted back at an appropriate interest rate and that relates to the long term government rate and now some business are terribly certain.....some business are incredibly different to predict, we try to stick to business which are easy to predict."

And he went on to describe that though what he always stick to are always what he understood, he too acknowledged the fact that what he did not understand may also be a better or superior investment than what he would invest in all those which he understood. But then he will not invest in something which he does not understand even though it may be a better investment because he cannot read the game but there are always others who can. So here is a very important insight which he pointed out, always stick to your competency.

Business economics of a newsprint in today's world

People will always want to be entertained and informed. However people just have two eyeballs, and they have only 24 hours in a day. Fifty or 60 years ago, media for most people consisted of the local movie theater, radio, and the local newspaper. Now people have a variety of ways of being informed faster (if not necessarily better), and have more entertainment options, too. But no one has figured out a way to increase the time available to watch entertainment.

In the nature of any business, whenever more competitors enter a business, the economics of that business tends to deteriorate. Newspapers are still highly profitable, but returns are falling. The size of the audience for network TV is declining. For years, cable TV was thought to operate in its own world, but that’s changing. Few businesses get better with more competitors – if you can find one, sell everything and buy this sort of business.

The outlook for newspapers is not great. In the TV business, a license from the government was essentially the right to a stream of royalty. There were basically three highways to people’s eyeballs, and companies like P&G, Ford, Gillette, and GM would pay a significant amount of money to be get on those highways and advertise their products to a mass audience. But as the ways to get in front of people’s eyeballs increases, the value of those highways goes down.

World Book used to sell 300,000 sets per year in the mid-1980s, each for $600. Then the Internet came along; it didn’t require printing or shipping, and people became less willing to pay for World Book sets. It doesn’t mean that it’s not worth $600. But competition has eroded returns.

So if you were looking at newspaper publishers as possible investments, what would you use as a margin of safety?

What multiple should you use for a company that earns $100 million per year whose earnings are falling by 5% per year rather than rising by 5% per year? Newspapers face the prospect of seeing their earnings erode indefinitely. It’s unlikely that at most papers, circulation or ad pages will be larger in five years than they are now. That’s even true in cities that are growing.

But most owners don’t yet see this protracted decline for what it is. The multiples on newspaper stocks are unattractively high. They are not cheap enough to compensate for the companies’ earnings power. Sometimes there’s a perception lag between the actual erosion of a business and how that erosion is seen by investors. Certain newspaper executives are going out and investing on other newspapers. It’s hard to make money buying a business that’s in permanent decline. If anything, the decline is accelerating. Newspaper readers are heading into the cemetery, while newspaper non-readers are just getting out of college. In other words, as the older population dies out, the younger population does not take over the readership of the newsprints. The old virtuous circle, where big readership draws a lot of ads, which in turn draw more readers, has broken down.

Charlie and Warren think newspapers are indispensable. Warren read four a day. Charlie reads five. They couldn’t live without them. But a lot of people can now. This used to be the ultimate bulletproof franchise. It’s not anymore.

Charlie used to think that GM was a bulletproof franchise. Now he’d put GM and newspapers in the “Too Hard” pile. If something is too hard to do, they look for something that isn’t too hard. What could be more obvious?

It may be that no one has followed the newspaper business as closely as they have for as long as they have—50 years or more. It’s been interesting to watch newspaper owners and investors resist seeing what’s going on right in front of them. It used to be you couldn’t make a mistake managing a newspaper. It took no management skill—like TV stations. Your nephew could run one.

Corporate Governance: Corporate directors accountability and level of independency

As published on Straits Times on Jan 01, 2007 about the question of how independent a corporate director can be. This subject has always been on the lips of both Warren Buffett and Charlie Munger but not many investors or governing authority really pay any heed to or have been doing anything much to remedy the question of the independency and impartiality of a corporate director, especially the independent director. The following is an interview with Charlie Munger on his thoughts recently with L.A. Times.

How did CEO compensation get so out of whack?

Some of the worst sinners are compensation consultants. I have always said that prostitution would be a step up for these people. "Whose bread I eat, whose song I sing."It isn't that the CEOs are such terrible people. It's that the system, with its envy-driven compensation mania, has developed to a place where it brings out the absolute worst in good people.

What about corporate directors? There's been a move to pay them more and try to make them more accountable. Would that help?

Paying directors more is going to make the compensation excesses harder to fix. The more you pay directors, the more the directors are going to want to pay the CEO. Putting more duties on the directors and giving them more money is like trying to extinguish a fire by pouring gasoline on it.If I were running the world, I would not allow directors to be paid at all. I would make directors be exemplars and serve just as they serve on the boards of Harvard and Yale.

What about putting limits on how much a CEO can be paid?

Congress tried to do that in 1993 by passing a prohibition on pay of more than $1 million. You can see how effective that was. I think you can assume that any law will be promptly evaded.I don't see blanket limits as a good idea, because it's not the dollar amount that's a problem. No one is the least mad when Tiger Woods earns $18 million. They figure he's earned it. What makes CEO pay so difficult is that only a few of the people who are earning these huge amounts are actually worth it. Everyone else figures they have to keep up or recognize that their guy isn't as good. Who wants the recognition that the company down the street has a remarkable CEO, but we have a mediocre klutz? I like the idea of high pay for people who are really worth it. The problem is that most of them are not. Every mediocre employee who rises through the ranks to become CEO thinks he should retire rich. It's crazy.

What is the solution?

The reason this has grown to such an extreme degree is that it is so hard to do something about it. It's like autocatalysis in chemistry — it's a reaction that just feeds on itself and keeps ballooning and ballooning. If more executive compensation issues required shareholder approval, I think that might dampen some of the excess. That has been suggested, and there is a lot of discussion around that subject. But there are also a lot of malcontented nuts in the world, and you wouldn't want the malcontents to get too much power. I don't know. Just because something is a serious problem doesn't mean that you can fix it. There's an element of tragedy in this because some very good people are acting in some very bad ways.But things are seldom so bad that you couldn't make them worse by a dumb intervention.

You don't seem to have much hope that things will change.

There's always hope. But frequently, when things are very excessive, the correction is very painful. Korea had cowboy capitalism, with low fiduciary standards, and things got worse and worse. They had to go through a total collapse and a huge scandal, but it's now largely fixed.I would like to see CEOs act as exemplars. I would like them to realize that they are setting an example when they are setting their own pay. But CEOs are very pompous and they assume they are right about everything. Saying that to them would be a total waste of breath. I don't want to spend my life nattering against my friends' pay. But if you think there's an easy solution, you don't understand the problem too well.We have had an enormous improvement in the garden variety of corporate fraud in America, in pretending to earn money that you did not. But the next level of reform will be much harder. In my opinion, not enough executives have gone to jail.

What the hell is a Leveraged Buyout (LBO)?

LBO business nature, on a legitimate basis, is a fraud. Not that it is fraud in the conventional sense upheld in the court of law.

In LBO, you need money to be in this business, but not a lot. Let's be honest about it, in fact, you may need more money to open a small grocery shop than you do to buy a $2 billion company. To buy or open a grocery shop, if it costs $20,000, you need $20,000. If you don't have it in cash today, you need to bring it by Tuesday.

But in an LBO, not only do you not have to bring it, you don't have to see it, you don't know where you're going to get it, nobody knows where they got it from. The whole situation comes from absolutely nothing.

But the more you need, of course, the less money you need. In other words, if there's money involved, you don't get involved in this business. This is a business for people who don't have the money, but who know somebody who has the money, but who doesn't put it up either. All they do is buy out somebody else business by injecting much debts into the balance sheet and within a short span of time, resell it to the public with all sorts of decorations.

The rules in LBO business is simple. 1) Never pay cash. 2) Never tell the truth. 3) Never play by the rules.

An example to estimating the intrinsic value of a business

Before reading on, it is important to recognize that no two people estimating the intrinsic value of the same business at the same time will produce the same value, even Warren Buffett acknowledged that he and Charlie never will have the same intrinsic value estimation. So this is just a general guideline with certain assumptions built in which some of you may find unrealistic or realistic - so it is important to cater to your own needs.

Intrinsic value is defined as the discounted value of all future cash flows or earnings that a business is estimated to generated during the remaining life of the business. So we can be talking about infinity or at least a period of more than 10 years. In order for intrinsic value to be accurate, it is important to compare between two different types of investments. I shall clearly illustrate the importance of having a really long term investing time frame if the decision of investment is based on intrinsic value. The basic concept to intrinsic value is that an investor is buying all the future earnings discounted back to present value of a business at a comfortable discount today. In other words, it needs a certain number of years of accumulated future earnings to make the intrinsic value to be worthwhile.

For the example in this exercise, we shall take the business of Home Depot. There are 3 main variables to consider in the calculation of the intrinsic value, namely, the book value, the historical return on shareholder's equity of the business, and the rate of return of the alternative choice of investment (in this case, it shall be the risk-free interest rate of government bonds).

In fiscal ended Jan 06, the book value for Home Depot was US$12.53. It was traded at about US$34 back then. The historical ROE is about 20%. And finally, the risk-free interest rate is 5.25%.

For an intrinsic value calculated for 10 years of earnings flow, the book value of Home Depot would have grown from $12.53 to approximately $77.6. Alternatively, if you have chosen to invest in risk-free bonds, the $34 which would otherwise be originally invested in Home Depot, would have grown to $56.72. Therefore, for the 10 years, the earnings from Home Depot generates about $65.07 ($77.6 - $12.53) while the earnings from the bond generates about $22.72. On the surface, the accumulated earnings from the business appears to be $65.07 for ten years before discounting it to present value. However, in order for the intrinsic value to be accurate, the accumulated earnings flow from bonds must be deducted from the earnings flow of the business, which gives a value of $42.35. Then this $42.35 must be discounted with an appropriate interest rate to get the present value of the intrinsic value today. In this case, the discount rate is 5.25%. So, after discounting for 10 years back to today, the intrinsic value of the earnings flow gives an intrinsic value of $25.39.

Then if you calculate the earnings flow for 20 years, the book value of the business would grow from $12.53 to $480.50 in 20 years. While the bond value would grow from $34 to $94.61 in 20 years. Thus, the earnings from the business is $467.97 while the earnings from the bond is $60.61. Again, the intrinsic value at the end of 20 years is $407.36, and then you need to discount it again at an appropriate rate to the present value, which gives $146.40.

Now to summarize the example for Home Depot. The intrinsic value based on 10 years earnings is $25.39, and 20 years is $146.40. The trading price is about $34 somewhere at the start of 2006. So if your time frame is 10 years, obviously, you are paying more than what the accumulated earnings in 10 years will be. But if you calculate based on 20 years, you get more than what you pay for. In fact, in you are paying $34 dollars for every $146.40 (in present value terms) of the next 20 years earnings flow.

And what is also clearly illustrated here in terms of book value is book value is meaningless as an indicator of intrinsic value if you should invest in a business. In fact here, you are paying $34 per $12.53 of book value which is a P/B ratio of 2.71. But it is capital well deployed since you will be getting $146.40 of future earnings in present intrinsic value today.

By the way, if you are wondering why is there a need to deduct the earnings which would otherwise be earned from bonds from the earnings of the business, here is the reason. In intrinsic value, it is in fact a comparison between two options. For example, between spending money in an education or to skip education and work straight away. So to compare which option is better in terms of future earnings, it is the difference in earnings between the earnings of having an education and the earnings of not having an education. To understand further on the basic concept of intrinsic value, do refer to one of my past subject on this.

Some ideas from Warren and Charlie on stock pickings

Firstly, it is important to pick out businesses which you can understand and naturally, when you can understand something, you tend to like them more. So, that narrows it down the pool of available businesses by a whole chunk of 90%. There will always be all types of things one do not understand, but fortunately, there is always enough for anyone to understand - therefore, you would not have to force yourself to understand something you do not understand. You have this big wide world out there and almost every company is publicly owned. So you have all kinds of businesses practically available to you and thus, it makes sense to go with the things you can understand.

Take for example, Coca Cola. Most people will be able to understand this. Since 1886, it is a simple business but it is not an easy business. Always distinguish between simple and easy. No one should go after an easy business as it will be easy for competitors. A simple business with a moat around it is the best form of business that an investor should look out for. Warren wants a very valuable castle in the middle and then he wants the Duke who is in charge of that castle to be honest and hard working and able. Then he wants a moat around that castle. The moat can be in various forms - for example, the moat around his auto insurance business, Geico, is low cost.

Anyone who is driving a car have to buy an auto insurance. You can't sell them 20 but they have to buy one. So what are these people going to base their criteria on when they buy? They will buy based on service and cost. Most people will assume the service is identical among companies or close enough. So they will do it on cost. So when Geico have a low-cost producer - they have the moat. All the time while you are having a castle whether with a moat or not, there are people out there who are going to attack it and try to take it away from you. So he wants both a castle which he can understand and also a castle with a moat around it with all kinds of sharks, crocs and gators thrown in to protect the castle. 30 years back, Eastman Kodak's moat was just as wide as Coca Cola's moat. If you were going to take a picture of you six-month old baby and you want to look at that picture 20 years from now or 50 years from now, so you want to evaluate what is going to look good 20 or 50 years ago. And if you are not a professional photographer, what will then be in your mind about photography? You need a peace of mind and that is what counts. Because Kodak is promising you that the picture you take today is going to be terrific 20 to 50 years from now is something that is very important to you. Well, Kodak had that in spades 30 years ago. They had what is called a share or peace of mind. Forget about share of market, it is share of mind. They had something - that little yellow box - that said Kodak is the best. That is priceless. But they have since lost it. They allow the moat to narrow. They let Fuji in and the moat starts narrowing in various ways. They let them get into the Olympics and take away that special aspect that only Kodak was fit to photograph the Olympics. So Fuji gets there and immediately in people's minds, Fuji becomes more into parity with Kodak.

As for Coke, you haven't seen their moat diminishing, in fact, its moat now is wider than it was 30 years ago. You can't see the moat day by day but every time the infrastructure that gets built in some countries that isn't yet profitable for Coke, that will be 20 years from now. The moat is widening a little bit each time. Things are, all the time, changing a little in one direction or the other. Ten years from now, you will see the difference. Warren wants the managers of his businesses to widen the moat to keep away competitors. That can comes through service, through quality of product, through cost, some times through patents and/or real estate location. So that is the kind of business he looks for.

Now what kind of businesses is he going to find like that? He is going to find them in simple products because he is not going to be able to figure what the moat is going to look like for Oracle, Lotus or Microsoft, ten years from now. Then it is almost certain to figure how their competitors will look like then. But it is easy to figure out how the chewing gum business will look like ten years from now. The internet is not going to change how we chew gum and nothing much is going to change how we chew gum. There will be lots of other products but is Spearmint or Juicy Fruit going to evaporate? It's highly not likely to happen. You can give anyone a billion and tell him or her to go into the chewing business and try to make a real dent in Wrigney's. He or she can't do it. That is how Warren thinks about businesses. He says to himself, "Give me a billion dollars and how much can I hurt the guy?" He can't do it and those are great businesses.

So Warren wants a simple business, easy to understand, great economics, honest and able management and then he can see about in a general way where they will be ten years from now. If he can't see where they will be ten years from now, he do not want to buy it. In other words, he do not want to buy any stock where if NYSE is close tomorrow for 5 years, he won't be happy owning it. If he buys a farm and he don't get a quote on it for 5 years, he will be happy if the farm does ok. If he buys an apartment house and don't get a quote on it for 5 years, he will be happy if the apartment produces the returns that he expects. People buy a stock and they look at the price the next morning and they decide to see if they're doing well or not doing well. It is bonkers. They're buying a piece of the business. That is what Graham - the most fundamental part - taught him. You're not buying a stock, you're buying part ownership in a business. You'll do well if the business does well if you do not pay a silly price. That's what it is all about. You ought to buy businesses you understand. Just like buying any other things, you ought to buy things you understand. It isn't complicated.

By the way, this is pure Graham method for which Warren admitted he was extremely fortunately or the luckiest event in his whole lifetime. That is to pick up Graham book (The Intelligent Investor) when he was nineteen, He got interested in stocks when he was 6 or 7 and he bought his first stock when he was eleven. But he was then playing around with all this stuff - charts, volume and all types of technical analysis. Then he picked up a little book that said you're not just buying some little ticker symbol that bounces around every day, but instead, you're buying part of a business. Soon as he started thinking about it that way, everything else like they say is history. It is very simple but not easy as what is layed out earlier. So he buys businesses he thinks he can understand and avoid all that he can't. There is no one who can't understand Coke.

In Buffett words, if he was teaching a class at business school, and on the final exam he would pass out the information on an internet company and ask each student to value it. If anyone that gave him an answer, he'd flunk him or her.

Investing is really all about putting money to be sure of getting more back later at an appropriate rate at an appropriate time frame. And to do that, you have to understand what you are doing at any time. You have to understand the business, your actions and your basics.

Business and investing wisdom from Warren Buffett

Warren remarked in Berkshire Hathawat 1993 annual report, "It's only when the tide goes out that you learn who has been swimming naked."

The sage of Omaha's much quoted, and misquoted, comment was about inadequate preparedness in the U.S insurance industry with catastrophe. Those words are also of immense value of the exuberance in every other things from Chinese to Indian to Vietnamnese euquities to Indonesian Corporate Bonds to recently the bullishness of Singapore properties. In all bull markets, it is typical for all kinds of investments - great or lousy - to all rise when the tide rises.

Developers recently paid HKD42,196 (USD5,444) psf in Hong Kong, smashing the 1997 record of HKD18,357. Six real-estate companies have tapped the Alternative Investment Market in London this year to raise money to invest in India. Their pickings? More than £1.2 billion, or $2.4 billion. And according to The Today newspaper in Singapore, an investor who paid about 14 million Singapore dollars, or $9.1 million, last week for a 4,400- square-foot, or about a 400-square-meter, apartment near the main Singapore business district turned down an offer to sell it at a 19 percent profit, or an annualized 1,000 percent profit. He wants more, the paper said. Worst of all investment in my view is property because property by itself is not a value adding product in the value chain.

Investors recently offered more than 450 billion yuan, or $58 billion, for the shares of a Chinese rail operator in Guangdong Province. Guangshen Railway needed only 10 billion yuan. Qantas is offered by a buyout firm to bring it private, and usually buyout will not even look at the aviation industry to buy. Some teachers pension fund has been buying container shipper terminals in the West Coast of U.S.A. I wonder what these fund managers operating the teachers' pension fund know about the shipping industry.

It is apparent in some sectors structural weaknesses are being brushed aside. Global investors who snapped up $2.7 billion in international corporate- bond issuances by Indonesian companies this year are not at all perturbed about the dubious legality, under Indonesian jurisprudence, of offshore special-purpose vehicles that are routinely used in structuring such deals.

Graft and nepotism remain big headaches 10 years after the Asian crisis exposed weaknesses in governance. In Taiwan, President Chen Shui-bian's wife is being tried on a charge of embezzling state funds. She rejects the allegations.

In Thailand, businesses linked to the deposed prime minister, Thaksin Shinawatra, are being investigated by the junta that overthrew him in September, alleging corruption and cronyism. And look at the "flip-flop" blunder made by the hastily assembled setup by the Junta. It seems that to chop down a single tree, they destroyed the whole forest just to get the tree down. It is so easy to undo 10 years of reform that is put in by the previous business savvy regime.

The legal system in Indonesia is at best a work in progress: The building that will house the all-powerful Constitutional Court, set up in 2003, is still under construction.

Malaysia looks both unable and unwilling to stop clinging to an anachronistic racial policy that does nothing to add much needed dynamism to its economy.

As long as the tide of liquidity runs high and is left undisturbed, investors do not care about anything else, much less about the basic weakness in the structure of what they invest in.

A nationalistic whiplash against foreign buyout firms in South Korea is being shrugged off as par for the course.

Meanwhile, the Bank of Thailand this week tried to tax the deluge of funds entering the economy and it got punished. Stocks collapsed. The move had to be hastily scaled down. An incompetent ruling party is bad enough, the worst scenario is to couple and compound an incompetent decision maker who flip-flops.

Will sobriety return in 2007? Will there be a decline in the amount of cash chasing Asian assets? Perhaps not.

And that is because the investment slump seen in Asian nations since the crisis may actually be part of a more widespread phenomenon. And also importantly, there is so much excess cash with the money managers chasing after a limited number of assets, and to make it worst, a much limited number of assets which are great business. So naturally many scraps are treated as "gold."

Behind the surfeit of worldwide liquidity, there is a global shortage of new fixed assets, Raghuram Rajan, the outgoing chief economist at the International Monetary Fund, noted in a speech earlier this month.
"The glut has spilt over into markets for existing real and financial assets — real estate, high-risk credit, private equity, art, commodities — pushing prices higher," he said.

Except for Asian central banks suddenly draining excessive liquidity, skinny-dipping will continue to be all thrills and no embarrassment until the midnight strucks but then, too many people does not know the time when they are high on dancing.

Method of evaluating and selecting stocks (Part 3)

Again, this is in response to Jojo. Yes, I totally agree that a summation of all FCF or otherwise could be known as the total earnings that a business will generate, till infinity is the best way to figure out the intrinsic value of a business.

And of course, the most difficult part is to determine a fair growth rate. And to determine this, it encompasses many factors from the quality of the management, the goal of the management, the plan for expansion or where the company is heading to few years down the road, the historical performance of the business and many more. To determine a growth rate is a large part for me personally can be attributed to both having an explicit plan for the future and to determine how the past performance matches the explicit plan at that time in point.

For example, a very recent acquisition of mine - Walgreens, I determined its growth rate and estimated value as described as follows, guided by the general guidelines as aforesaid.

In Walgreens latest annual report ended fiscal 2006, they plan to operate 7000 drugstores by 2010 as stated explicitly. This represents a 400 stores per year increase from today. So you can be pretty sure they are still growing at some decent pace.

So how sure can one be that they can achieve their goal? Then, we shall back-track to year 1994. In 1994 annual report, they had a plan to grow to 3000 drugstores in 2000. And they exceeded it. So if we compare the period b/w 94 to 00, & 06 to 2010, you will see that they grew from 1966 stores in 1994 to 3181 stores in 2000 which represents an increase of 61% from 94. If they can grow to 7000 stores in 2010 from the existing 5481 stores at end Aug 2006, it is about a 27% increase. Though if you compare it period to period, obviously the one from 94 to 00 is growing much more but then, it gotta be so when it is easier to grow it when on a smaller scale. But if you look at its per store sales, in 94, a store generated about USD4.7M, in 2000 it was US$6.67M, in 06, it was US$8.68 millions, in 2010, I estimate at about US$9.68 millions. I think my estimation is pretty conservative. I maintain a file to play around with the valuations, in 2010 if you use a PE of say 25, it can hit a price of USD74. In 2008, if you use PE of 22, it can goes to US$48.

Then it is important to be conservative in valuation in order to have a margin of safety too. And the calculation I did for the above are pretty conservative in my view if it was to compare it to how the market valued Walgreen a decade prior from now. If I were to use the same set of constants to calculate "Walgreen estimated value" from 94 to 00, the actual result, i.e. the actual average trading price then, was way a lot more than what I estimated. If I had bought in 94 at USD4.84, my valuation done in 1994 for the stock price was estimated to be about US$13 in 00, but it hit US$29.63 in reality....not only in that year was my calculation way off from the actual, any year before that is also way off but it is better to calculate conservatively.

Method of evaluating and selecting stocks (Part 2)

Again this is in response to Jojo, a fellow value investor, it's great to share ideas with someone who has a similar mindset towards investing, though may not be exactly the same in totality but the basic foundations are the same.

I too subscribe in total to Benjamin Graham basic notion of investing which is to find a dollar worth of business for 50 cents. This may be sniffed out in many ways, for instance, through the pure Grahamites method, or the improved method like how Warren and Charlie did.

Ok, I shall go part by part to elaborate how I select my business thus far. As to what I said earlier, I got to add that the ratios are just a trigger to consider investing in it. Well, PER and PBR are important triggers to telling you if a business is undervalued in a large part but it don't give you an idea of what the intrinsic value is.

The level of margin of safety is dependent on how confident an investor is to his valuation. Let's say if you are driving a 10-tons truck across a bridge over the Grand Canyon, you would feel you need a lot more in the way of margin of safety. But if you are driving over the Sin/Johor causeway, you need a lot less.

As for intrinsic value, I do not necessary base on that for my decision in investment. This is because if I can find a stock that is a great business and that it will survive, and have certain organic growth in the years ahead, and coupled with a valuation which is almost at its low for a long time, say, 10 years or more, I am sure the intrinsic value of its future flow of earnings at the present value today will be worth much more than the price that I pay today. Further, I got to add that I like to consider businesses which has a long history of getting good average return on shareholder equity.

Though I do not calculate the intrinsic value as always in all my purchases, I do have a method to calculate it. But the method is not simple and it is just an estimation though it is an all-important concept that offers a logical approach to evaluating the relative attractiveness of investments and businesses. To start, intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. So what is meant here is really a long run for all the great businesses who has a great moat that has the durability to survive and grow its moat and more importantly, the durability of the moat. It is quite pointless to do an estimation of intrinsic value if the duration is 3 years, 5 years or such because you will not be able to see the effects of cash flowing in to make up for the price you pay at with such a short time frame.

And the inputs to the calculation of the intrinsic value is all important as well. And it has to be changed yearly when interest rates changes or future cash flows are revised.

And what importance intrinsic value brings to the table is it also helps to determine the fair amount of what you should pay irregardless of what is carried on the book or its book value at the point of valuation. In other words, book value by itself is meaningless as an indicator of intrinsic value.

Here's an example on how I calculate the intrinsic value for a business, I shall take this business called, USG, as an example.

In calculating intrinsic value, it is basically to compare between two options. In this case, we are to compare between investing in USG or to invest in risk-free equities like government bonds.

The process of estimating intrinsic value is firstly, to estimate the earnings that the business (USG) will receive over its lifetime or for the duration of the time frame you are willing to invest for (10, 15, 20 years or so on). Then once you manage to estimate the earnings for the duration, you must substract from that figure an estimate of what the investor would have otherwise earned if he had deployed it in some other securities like risk-free bonds. This will give you an excess earnings figure which must then be discounted at an appropriate interest rate back to the day you invested in. The dollar result equals the intrinsic economic value of the investment. This figure will then give you an idea of how much you should pay for at maximum and it brings you back to the old Aesop's axiom of "if a bird in hand is worth two in the bush."

Here's the exact intrinsic value that I calculated for USG and see if it makes much sense to you. But be cautioned that the outcome of it at the end is really dependent on two important variables, the current interest rate that I used at 5% for risk-free interest and the return of equity of the business at roughly about 26% historically.

A few months back, USG was traded at US$46.50. I used a time frame of 11 years. Then the book value of USG was about US$20, and by the year 2016, it is calcuated to be worth about $210. On the other hand, if I had opted to invest in bonds which pays 5% till 2016, the initial value of $46.50 would grow to US$75 by 2016. Obviously, at first glance, USG is a better investment but that is not the intrinsic value and it does not show you what the present value is for USG future value. So now, you got to take the difference between $210 and $75 and discount it back to today at an appropriate rate of say, 5% again. So the present value of the difference which is $135 is worth $82.90 today. So effectively, you are paying $46.50 for $82.90 of future cash flows.

I shall give another example that may make it much clearer in distinguishing the intrinsic value to the price that you should pay. I think some people like to value things too much by having the book value of the business or something as the yardstick but it isn't exactly a good way to do so.

You can gain a lot of insight from a college education. Think of education cost as its book value. And if this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college over a job. Here is how it works. Firstly, you must estimate again the earnings the student will receive over his lifetime and then subtract from that figure an estimate of what he would otherwise have earned had he lacked his education. Again, the difference will give you an excess earnings figure, which must be discounted at an appropriate interest rate back to graduation day. This will then give you the intrinsic value. So the next question is if the parents of the student got his money (the cost of the education which is the book value) worth? Some students will find that the book value of their education far exceeds the intrinsic value, which means the parents or who ever paying for his education did not get his money worth. In other cases, the intrinsic value of an education will far exceed its book value, a result which proves capital is wisely deployed.

What we can glean from these 2 cases is clearly that book value is meaningless as an indicator of intrinsic value.

I am not sure if I describe clearly or I may have missed out any important point, which you may point out to me. I am extremely interested to learn more and improve on my method.

Aside from the intrinsic value, just as important, I can afford to hold businesses like these for many years or even throughout my lifetime because they have great business models which gives investor great returns if gotten at a fair price, or even better at a great price.

As for the value of USD, yes, it will definitely fall in the future because they are buying more than they are selling. So slowly, they got to sell away their assets and things like that and it will cause their currency to be worth lesser. Well, in any thing, there will be rock bottom or hit its bottom and then goes up again. So if my time frame for USG is 11 years, I really cannot tell if the exchange rate today of 1.55 will be worth more or less in 11 years but somewhere between now and then, it will probably be worth less. If I recall, in my poly days in mid 90s, SGD hit 1.42 to the Dollar, in 2002 it was at 1.82. I am no currency expert but if my time frame is long enough, I do not worry about the exchange rate of USD to SGD. Moreover, Singapore imports more from US than US imports more from SG, the only thing is SGD is pegged to a basket of currency which it is not easy to predict which direction it goes. I am pretty comfortable with the exchange rate for now which is probably at the middle between the bottom of 1.42 and high of 1.85 in recent 10 years.

Method of evaluating and selecting stocks

This is in response to a question by Jojo on how I evaluate and select businesses. Since last November where I picked up Value Investing and made my first stock purchase, my method of evaluation and selection has evolved from the classic Benjamin Graham concept to an approach which is an improved and extended concept that originated from Benjamin Graham’s tree of thoughts which is to buy a dollar for 40 cents.

The classic Graham method advocates purchasing businesses 1) for 60% of current net asset value or working capital, 2) uninterrupted dividend payout record for 10 years or more, 3) Price to book value ratio of not more than 1.5 and so on. As the years went by, the bargain which met Graham standard got lesser and lesser. By and large, at the time, he was living in the 1930s, the situation was totally different. You could get a business that is worth less than the sellout value or working capital, close shop, fire all the workers and take home the capital. In today's world, it is simply not possible or at least they didn't.

However, having said that, his basic notion is very much applicable today or timeless. He had this concept of value to a private owner - what an enterprise would sell for if it is available and in many cases, it is calculable. As the years moved on, the disciples of Graham got wiser as those obvious bargains disappeared and they changed the calibration of measuring a bargain. Graham would be horrified at certain calibration of value investing especially those that involve paying 2, 3 or 4 times book value which he would never even consider touching. But there are still many who stick to the classic Benjamin Graham route - not that it is no longer safe or good to practice, but it will not give an above average return - it is like the man with the hammer, in Charlie Munger’s words, everything looks like a nail.

So, people started to look for bargain in a different way. People kept changing their definition so that they could keep doing what they'd always done. And it worked pretty well. So in effect, the basic Graham intellectual system is a very good and timeless one.

The best notion he crafted was "Mr. Market." To Graham, it was a blessing to do business with a manic depressive who gave him a series of options all the time. On some day, he wants to buy from Graham his stake at a very high price. On some other day, he will offer to sell to Graham at a price which is very low. To buy or to sell is all up to Graham where he has a choice or to totally ignore Mr. Market. And this is one of the most useful construct one can have for his entire investment lifetime.

However, to stick with the pure Graham method today, it is very tough to get an outsize return because Graham would not consider many things which are essential to getting an outsize return. To be fair to Graham, he is more of an academic where he wanted to construct an investment framework for people from all walks including the layman. So his ideas have to be easily understood and practiced by the ordinary people. Thus, he would not consider bringing in any idea that the layman would otherwise not understand or will be accessible to and that is exactly how he preached and practiced it.

So what are the things he did not bring to the table to enhance the chances of getting a better return? For example, he would not talk to management which he believes most ordinary shareholders do not have access to and secondly, he would not consider buying any business which is priced a couple times or more of book value even if the business has a superb underlying business economic model. And the most important extension to the classic Graham intellectual system is to first and foremost consider buying better business at a fair price even if it is a few times book value. In all cases, the notion of value investing is to find mispriced bet and gain more than what you pay for, and this may not be just limited to discount to book value, free cash flow and the old-school way of value investing.

And one of the best insights to selecting businesses is mentioned by Charlie Munger, "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." So the trick is to buy into better businesses.

Starting as Grahamites is totally fine and will work out fine or at least average for the rest of your investment lifetime. But then, to get better returns, it is important to recognize that buying companies which are 2 or 3 times book value can be a hell of a bargain because of the momentum implicit in its position and sometimes combined with an unusual management present in an individual or some other system.

Plainly speaking, it is better to consider investing in better business, evaluate the moat of a business, you may want a simple business but not an easy one where anyone can take over its place easily, look for a great and honest management, buy into businesses you can understand (for me I avoid tech stocks as much as possible and any business that always require change to maintain its existence), stick to your circle of competency. It is also importance not to buy a business which has a great management but lousy business economics as most times, it is highly unlikely a business would turn over due to the brilliance of an individual if a moat is missing. Conversely, if you come across a situation where you have to bet between a brilliant manager or a brilliant business, bet on the business. Also, if you have to bet between a fair business available at a great price or a great business available at a fair price, bet on the latter.

Here, I shall illustrate of how far I have evolved to from a pure Grahamite to buying businesses at an improved method from the classic Graham way.

Grahamite stock - Kingboard and United Food.

1) Kingboard - Late last year, the stock was available at slightly below 26 cents per share. At that price, it was selling at slightly less than 6 of 2005 earnings. Discount to NAV of 44%. Current ratio of more than 2. Sadly then, all I looked at was through the back screen rather than the front windscreen. I could not tell where the business will be 5 years down the road. And even if they survive, I could not tell explicitly what their plan is and how they are going to grow their business.

2) United Food - This is a total Ben Graham stock. Early this year, the stock was selling at 24 cents or so. Some slight discount to Net working capital. A huge discount to NAV. No debts and so on. Sadly, the reason of looking into the future is not calculable. Today, the discount to NWC is much more, traded at 18.5 cents, luckily, I sold it at about 30 cents somewhere in Apr this year. But if you are to bet on this today, it is a totally mispriced stock and the returns could be pretty significant.

Such stocks are safe stocks because of sound financial standing but the problem is the business economics are not great. They are perhaps only fair or good at most. But such stocks you can be sure that you are very well protected because essentially you are paying 50 cents for a dollar. You need lots of patience in pure classic Grahamite method and a control over your temperament for being on the other side of the fence when the majority is against you. Well, value investing is just as exciting as watching grass grows.

Therefore, after reading more on both Warren Buffett and Charlie Munger, I changed the calibration by buying into better businesses. I like businesses like Walgreens, Wal-Mart, Lowes, Home Depot, Radian, USG, Coca Cola, Harley Davidson, McDonalds, Johnson & Johnson and many more. I bought USG, Walgreens and Radian. I want to buy Lowes and J&J if I have spare cash now. All the rest it is just a matter of waiting for the right time. In investing, always study a great business, keep it in mind, keep studying and wait for it.

Walgreen - I bought it at slightly above US$40 per share. At this price, it is the lowest for the past 52 weeks but that is beside the point and unimportant unless you are a total momentum or technical buyer. At US$40, it is priced at about 4 times book value, 23 times earnings. However, considering the business historically earns 19% to 20% on shareholder's equity, at this price, I am buying at a future valuation of 2.25 times book value, 13.55 times earnings into year 2010. And most important, I can both understand the business model which is very simple and how they plan to grow their business into the future by year 2010. The business they operate is retail of drugs. They operate round-the-clock drugstores in the States. In retail, the overall business model is to stock items that the consumers are seeking for in a timely fashion and conversely to sell these items while generating the most sale per square feet of retail space. At the end of fiscal 2006, Walgreens operate 5461 drugstores, they intend to grow up to 7000 stores by 2010. That is to say you can be pretty sure sales and profit will grow and thus, shareholders will ultimately by getting more profit and value per share. The next question is how confident Walgreens will be able to achieve 7000 stores? In 1994, there were 1966 stores, they had a plan then to grow to 3000 stores by year 2000. In year 2000, they operated 3181 stores. And the best thing here while growing is they do not need to dilute shareholders stake by selling any new shares to fund their expansion which is very common in many companies. So for each original shareholder in 1994, they had a share of profit of US$0.29 per share, in year 2000, they had a profit of $0.75 per share. In fiscal 06, it was $1.72. And the business is coupled with a great management where they focused on the business rather than on the share price. The CEO mentioned something to the effect that "if a business is well taken care of, the share price will take care of itself and the share price is one matrix where he has no control over." I think that is honest management and bam, you have both a great management and a great business which has more than 100 years of operations and counting.

As for the rest of the great businesses, it is too long to even put the reasons down here.

To summarize, to get better returns and also importantly so as not to worry about the daily quotes on the tickers, it is important to buy into better businesses because if you get a great business at a fair price today, you can essentially put it aside, can it up, sit on it and maybe some many years down the road and you look at the price and value, you will have a pleasant surprise. And also just as important, you will have missed a lot of unhappy and tensed experiences.

Basic to being a good stock picker (Part7)

Another very simple effect that is very seldom seen discussed either by the investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that will work out is that after taxes, you get to keep 13.3% per annum.

In contrast, if you bought the same investment buy had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% - or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you have chose to sit back for long, long stretches in great companies, you can get a huge advantage from nothing except from the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.

However, in terms of business mistakes, trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. Terrible mistakes are made from people being overly motivated by tax considerations. Anytime someone offers you a tax shelter from here on in life, shun it.

In fact, anytime anybody offers you anything with a big commission and a 200-page prospectus, don’t buy it. Occasionally, you’ll be wrong if you adopt this rule. But, over a lifetime, you’ll find yourself a long way ahead – and you’ll miss a lot of unhappy experiences that might otherwise reduce you love for your fellow man.

There’re huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait. Firstly, you’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.

And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes on your behalf? Lots of luck.

Are there any dangers in this philosophy? Yes, everything in life has dangers. Since it’s so obvious by investing in great companies work, it gets horribly overdone from time to time. In the “Nifty-Fifty” years, everybody could tell which companies were the great ones. So they got bided up to 50, 60 and 70 times earnings – thus the name “Nifty-Fifty.” And just as IBM fell off the wave, other companies did too. Thus, a large investment disaster resulted from too high prices. And you got to be aware of the danger.

So there are risks. Nothing is automatic and easy in life. But if you can find some fairly priced great companies and buy it and sit, that tends to work out very, very well indeed – especially for the individual.

Within the growth stock model, there’s a sub-position: There’re actually business that you will find a few times in a lifetime where any manager could raise the return enormously just by raising the product prices – and yet some of they haven’t done it. So they have huge untapped pricing power that they’re not yet using. That is the ultimate no-brainer.

That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance still stay right up there.

So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies.

And at Berkshire Hathaway, they are the largest shareholder in Coca Cola – which had some untapped pricing power. And it had brilliant management. It was perfect.